What a 1920s farm bust reveals about financial crises

Bank failures can be virulently contagious. Witness the historic meltdown of Wall Street and the broader financial system over just a few days in September 2008, when the collapse of Lehman Brothers sent ripples of self-fulfilling panic across thousands of intermediaries and counterparties big and small. In such a failure, the system freezes. No one lends. With few or no bids for their assets, sellers seek fire-sale prices that further impair their finances. Forced sales consume liquidity, depressing asset values at healthy intermediaries and causing contagious runs.

To understand this spiral, two researchers turned to data about another systemic financial meltdown—this one involving US farms in the trying 1920s.

Professor Raghuram G. Rajan, now India’s top central banker, and Rodney Ramcharan of the US Federal Reserve Board, studied bank failures during the collapse in American agriculture just ahead of the Great Depression, when plunging crop prices combined with excessive borrowing ravaged the countryside and its banks. (Think Jimmy Stewart in It’s a Wonderful Life, only in farmer’s overalls.) During that agrarian panic, banking regulators liquidated the assets of failed banks as quickly as possible.

At the time, local banking markets were segmented due to heavy interstate regulations and the steep transaction costs imposed by distance. Out-of-state banks were not allowed to extend loans to farmers in nearby states. Even if a farmer wanted to deal with a bank several counties over, it was difficult, as few farmers had cars, or phones.

Rajan and Ramcharan characterize this as “an almost ideal laboratory to study” their questions: Can the loss of financing capacity cause assets to sell at a discount relative to fundamental value? Can it also render asset markets more illiquid? And can
these forces lead to contagion, propagating shocks through time?

The authors use a new dataset of county-by-county land prices, sales records, and banks’ recovery values. They hand-collected data from the US Office of the Comptroller of Currency’s annual reports, the 1920 Decennial Census, and that year’s affiliated US Agriculture Census.

Their findings: in areas with more banking-sector distress, recovery rates among failed banks were significantly lower. Moreover, local financial-sector distress was associated with lower land prices and a decrease in land transactions.

The researchers also find evidence that bank suspensions were correlated within those geographically proximate areas in the same state. This suggests land sales that depressed local land prices might have been critical to transmitting banking-sector distress.

The fraction of a failed bank’s assets recovered within three years after failure—the “three-year recovery rate”—is strongly negatively related to subsequent bank failures in that county, the authors learned. The upshot: when a bank’s recovery rate is higher, there are fewer subsequent bank failures nearby.

Moreover, recovery rates are also related to the relative size of the failed bank—recovery rates are likely to be high in areas where the size of the bank that failed is relatively small compared to the initial available financing capacity in the market. By contrast, the bigger the size of the failed bank in relation to its neighbors, and thus lower the relative financing capacity left in surviving banks, the lower the subsequent recovery rate. Recovery rates are likely lowest when there are no nearby banks able to purchase the assets of the failed bank.

In short, the researchers underscore why bank failures are so contagious, finding that when bank failures reduce local financing capacity, that reduces the recovery rates on failed assets of nearby banks, depresses local land prices, renders land markets illiquid, and accelerates subsequent financial-sector distress among nearby banks. Reduced capacity also leads to lower transaction volume.

Otherwise perfectly good assets—be those fertile, unexploited acres in 1925; secured, prime real-estate bonds in late 2008; or blue-chip, high-quality shares in 2009—will trade at a discount relative to fundamental value when they are sold by distressed owners. No matter how hale and performing an asset may intrinsically be, its real-time value is inextricably linked to the availability of financing. When banks stop extending credit, asset prices will almost reflexively fall.